The Bank Of Japan’s Ill-Advised “1% Rule”

James Saft is a Reuters columnist. The opinions expressed are his own.

The Bank of Japan seems to be running its own fun-house version of monetary policy, intervening in equity markets when they fall.

Dubbed by traders the BOJ’s “1% rule,” the central bank is apparently stepping in to buy Japanese shares on days when they end the morning down 1 percent or more on the previous day’s closing price.

While the BOJ will not comment on its purchases or policies, Japanese news organization Nikkei points out that since mid-December, the central bank has bought ETFs on each of the 18 days the Topix index fell by at least 1 percent in morning trading.

While it is hard not to be sympathetic to the BOJ, which is struggling to kindle both demand and inflation after the devastating earthquake and tsunami, the tactic of buying when markets fall sharply is more of the same failed medicine, only worse.

Such an implied insurance policy for investors only further distances stock valuations from reality, makes more likely lousy allocation of capital and, ultimately, sets up the market for a nasty bout of selling if ever the BOJ ends the policy.
It is also, very possibly, a foretaste of the kind of folly that might emerge from the U.S. Federal Reserve if the current economic lull deepens into a double dip recession.

While the amounts the BOJ is spending on buying shares is small in the scheme of things, it is having an important psychological impact on traders and investors, who have grown used to official buying if the market has a bad morning.

The BOJ in October announced a new policy of buying exchange-traded funds and Japan real estate investment trusts (J-REITs). The ETFs track the Topix or Nikkei 225 indices, while the real estate trusts must be AA rated or higher. The plan was part of a larger $61 billion plan to buy up a variety of assets, including corporate debt.

There is no way of getting around it; central banks buying shares are picking winners and losers in theeconomy and are moving ever further away from their core mandate of price stability. Why on earth would anyone think a central bank has a better idea of how to allocate capital in the economy than the sum of all market forces, even given how imperfect and prone to error markets are?

Why too would a central bank want to favour large listed companies and real estate over the rest of the economy? Why not buy used cars and junk them, or simply buy up office buildings and burn them to the ground? At least those actions, deranged as they are, would have an actual impact on supply and demand in the actual economy. As it stands, at best, the BOJ’s actions simply flatter people’s ideas of how much their financial assets are worth. At worst it simply facilitates cynical buying and selling by people trying to front run the BOJ’s assumed policies.

FEEDBACK MECHANISMS SHORT-CIRCUITED

This gets to the heart of the self-defeating aspects of much monetary policy, both in Japan and in the U.S., as it has been practiced in the last 15 years. One of the main effects of all that has been done, bailing out after crises, engaging in quantitative easing, is to short-circuit the normal feedback mechanisms that should travel between financial markets and the real economy.

It is very much like pain medication; good for temporary relief but a poor long-term solution. If you have an injured knee and take opiates to mask the pain you may walk a bit more in the short term, but perhaps a lot less over the long run. We’ve been upping our dosage since about 1998, and it’s not working well anymore.

Buying up equity and property-share funds may be the most extreme and egregious example, but it is probably not the most important. That honor belongs to buying up government debt, which has helped to nullify government bond markets as a benchmark by which the world can measure risk.

In the old days, and really this is before China began buying up Treasuries as an adjunct of currency manipulation, people thought of government bond yields as a north star against which the relative risk of everything else could be gauged.

Investors really have no idea where they are anymore, and in this way all of the efforts to suppress or mask risk by intervening in asset markets have only increased the likely amount of ignorant risk we are collectively taking on. The subprime and subsequent crises are examples of this, but surely won’t be the last.

This is surely throwing up attractive opportunities for clever investors, but is not likely good public policy.
For Japan and the U.S., as difficult as their respective situations are, the best thing would be to stop supporting asset prices and let the feedback mechanisms reassert themselves. They will in the end anyway.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

- Reuters

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